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The Road Less Traveled: Non-Standard Early Stage Funding Paths
As the seed stage that atomized and series A rounds have become larger and more traction based, the paths to series A have changed. The baseline path to series A has tends to look something like this:
Raise $0 — $500K in angel or pre-seed funding -> Raise a $2–3M institutional seed -> Raise an A.
This is the logical path that one would think is pretty “standard” for early stage companies. There may be some twists and turns along the way, like a bridge or seed extension, but I think something like this is plan A for most founders.
But I’ve recently noticed a few common offshoots of this path that I’ve seen repeated a number of times. I’ll describe three of them, and share some pro’s and con’s of each.
1.The Pre-YC Pre-Seed
The challenge with pre-seed rounds is that pricing will sometimes be pretty dilutive. Unless a founder has angels interested who are not really price sensitive, a founder might find themselves selling a pretty big chunk of their company for not that much money.
One way that I’ve seen some founders hack this is to raise their pre-seed in the midst of YC applications and interviews. I don’t know if this happens intentionally, but if so, it’s a pretty clever strategy. If the company does not get into YC, nothing has really changed. But if you do get into YC, it creates a great foil for pricing negotiations. My experience is that YC partners tend to encourage founders to hold off on taking more money shortly after getting into YC, arguing that their value will increase significantly in just a few months. Whether this is true or not, this is a credible argument, and creates some FOMO and pricing pressure for investors that may have been circling.
The positives of this path are that you probably get better terms for your pre-seed and you get to be part of YC. This creates a stamp of credibility and may help you raise your next round on amazing terms if you are one of the most desireable companies at demo day. The downside is that YC is itself quite dilutive, the program itself may not be a great fit, and there are many many companies out of your batch that won’t be one of the anointed winners. So your net dilution may end up worse and you may miss out on working with a really hands-on pre-seed partner early in your company’s life.
2. The Pre-seed to Pre-traction A
It’s commonly said that companies with a little bit of traction might actually have a harder time raising money than ones that are raising purely on promise. Once early data exists, there are all sorts of comps out there that create some gravitational pull towards “market” pricing. But prior to actual data, valuation ends up being driven entirely by demand, competition, and ownership targets.
Because of this, some founders with a lot of prior success can raise a $5M+ series A as their first round of financing pre-traction. In some cases, this happens out of the gate, but I think more commonly, the founder self-funds the company for the first 6–12 months before she is in a position to go straight to A. The company in this situation probably doesn’t have much traction, but has assembled a team and some compelling proof points that get new investors over the hump to create a competitive dynamic for a round.
Perhaps some of the most promising founders out there are folks with excellent experience and credibility, but could use a little bit of capital to get to the point that they raise an A before real traction. In this case, they raise what would look like a pre-seed round ($1M or less) at single-digit pre-money pricing. But then they leverage that to go out to raise a series A in 6–12 months, often pre-launch. I’ve seen this several times now, and I’ve seen some other founders that had the option to do this, but still ended up raising a traditional institutional seed to work with a particular partner.
The positives of this path is that it gives optionality to the founder. They don’t dilute themselves too much in the initial pre-seed, and they skip the typical dilution of a large institutional seed. If the strategy is successful, they will emerge with less dilution and more funding more quickly. And if the market doesn’t bite for the series A, they can revert to a more traditional seed round, often at better than market terms or with really strong investors.
The downside is that raising a lot of capital before PMF is often a pretty risky proposition, and could lead to premature scaling as well as a valuation overhang down the road. There also may be some adverse selection in the funds that are willing to do a series A pre-launch, either because they are worried that they could never win the deal otherwise, or because their funds are so large that they can treat even the series A as an option.
3. The Greedy Second Seed
Second seeds or seed extensions are usually raised from a position of weakness. Plan A for most companies is to accomplish enough during a seed round to be in a strong position to raise a series A from great investors. And if that doesn’t happen, founders and investors are often stuck in a tricky situation.
But increasingly, I’m seeing (and am part of) second seed rounds that are happening much more from a position of strength. When at one time, insiders would hold their nose when doing a seed extension, more funds that I respect are aggressively trying to catalyze second seed rounds prior to the series A.
The reason for this is that more seed funds have gotten bigger and can start to act like a bit of a hybrid between a seed and series A fund. In select situations, the fund can see that something is working, and catalyze an inside round where they are able to pick up a few extra points of ownership while putting the company into an even stronger position for their next round. Sometimes, for a seasonable business this approach also allows a company to raise money at the most favorable time with the most market tailwinds showing momentum in the business.
The positives of this strategy is that you end up working with investors you already know to put your company in an even stronger position before your next raise. The negatives is that it’s hard to determine a true market price for these rounds, and you run the risk of giving existing investors too good of a deal and having the same net dilution after the series A. From the investor’s perspective, you don’t have the benefit of an external signal of demand for the round, and also run the risk of putting more dollars at risk without a new capital partner to share the load.
There are a few other non-standard paths emerging that I’ll save for a future post. If anyone wants to share others that they’ve seen, I’d love to hear it. Overall, I think we are seeing that what used to be a fairly formulaic early stage funding journey has become more varied, given the breadth of investors and strategies that exist in the market. Overall, I think these developments are positive ones for both founders and investors. It gives founders more options, and some of the stigma around intermediate rounds has gone away. And investors that have the flexibility to play across the seed spectrum can pick their spots to find a variety of ways to work with founders and businesses that they love.